What Are Absolute, Annual Returns?

Anmol Garg, email

I have just started investing in mutual funds (MFs) and have seen that they mention two kinds of returns—absolute and annual. How are they different?

Absolute return is the actual percentage change in the value of an investment over a specific time period, without taking into account the effect of compounding. It is the actual profit or loss earned on an investment over a period of time.

Let us understand this with an example. Say, you invested Rs 10,000 in XYZ MF scheme two years back and now its value is Rs 12,000. The formula is: Absolute return = ((Current value of investment – Initial value of investment)/Initial investment)*100

In this case, the absolute return is (12,000-10,000)/10,000=0.2. Multiply this by 100 to get it in percentage. So, the absolute return or total return in this scheme is 20 per cent.

Annualised return is the average rate of return per year over a specific period, taking into account the effect of compounding. It is calculated as an average annual return over a specified period and is useful for comparing MFs. To calculate annualised return, you need to know the time period of the investment and the total or absolute return. The formula is: ((1+Total return)^(1/Investment period in years))–1

So, here, annualised return = ((1+0.2)^(1/2))–1 = ((1.2)^(0.5))–1 = 0.0954. Multiply by 100 and it comes to 9.54 per cent. It means the fund generated an average annual return of 9.54 per cent over two years. It is also known as compounded annual growth rate (CAGR) and is useful to know returns on one-time investments.

However, in reality, annualised return is calculated on an absolute basis for less than one year holding period and on an extended internal rate of return (XIRR) basis for more than one year of holding period. XIRR is used to calculate returns where there are multiple transactions at different times. It reflects the returns considering both the timing and the amount of each cash flow. You may invest and redeem MFs, or increase your systematic investment plan (SIP) contribution, at different intervals. It captures all this and provides a more accurate measure of performance.

Uma S. Chander, CFP®Handholding Financials

Piyush Wadekar, email

I have received a decent amount as bonus. Should I invest it or prepay a part of my home loan?

Based on the terms and condition of your home loan, if it is at a higher rate of interest, pre-paying your home loan would be ideal. Home loans do give tax advantage.

However, if your equated monthly instalment (EMI) is not much of a burden to you, that is, if it is less than 30 per cent of your income, and the rate of interest is also reasonable, then investing the bonus into some investment where your expected returns are reasonably more than your home loan interest rate would be a good option.

But do consider paying off a part of the home loan and reduce the principal outstanding amount.

Hina Shah, CFP®Financial Coach and MF Distributor

William Jones, email

I have some investments in mutual funds across small-, large-, and mid-caps. I will be retiring in four years. By when should I liquidate my equity investments and transfer them to debt? Should I invest in equity even in retirement?

It will be prudent if you start liquidating your equity investments at least two years before your retirement and start transferring them to debt instruments.

If you have the risk appetite for equity even after retirement, then you can definitely continue investing in equity funds. Consider investing in hybrid category funds, which should constitute the majority of your equity exposure after retirement.

Suhel Chander, CFP®Handholding Financials